What you'll learn
A budget is a plan expressed in money for a defined future period. It does three things at once: it forces management to think ahead, it coordinates departments that would otherwise plan in isolation, and it provides the yardstick against which actual performance is later measured. That last function is where variance analysis begins.
The central technique of this topic is the flexed budget. Comparing actual results at 11,000 units against a budget built for 10,000 units tells you almost nothing, because every variable cost was always going to be higher. Flexing the budget to the activity level actually achieved strips out the volume effect and leaves the differences that management can genuinely be asked about — did we pay more per unit, did we use more per unit, did fixed costs overrun.
By the end of this topic you should be able to explain the purposes and stages of budgeting, prepare a flexed budget, calculate and interpret the variances it produces, prepare a simple cash budget, and evaluate budgeting as a control system rather than merely describing it.
Key terms and definitions
Budget — a plan expressed in financial terms for a future period, approved before that period begins.
Budget period — the span a budget covers, commonly a year divided into months or quarters.
Principal budget factor (limiting factor) — the constraint that determines what everything else is planned around, usually sales demand.
Master budget — the consolidated budgeted income statement, statement of financial position and cash budget.
Fixed budget — a budget prepared for a single planned level of activity.
Flexed budget — a budget restated at the activity level actually achieved.
Variance — the difference between a budgeted and an actual figure. Favourable (F) where it increases profit, adverse (A) where it reduces it.
Cash budget — a month-by-month forecast of receipts and payments, showing the closing balance.
Zero-based budgeting — a method requiring every item to be justified from nothing each period, rather than adjusting last year's figure.
Core concepts
Why businesses budget
Four purposes are worth being able to state and distinguish. Planning forces management to think about the future rather than react to it. Coordination makes departments consistent — production plans for what sales expects to sell, purchasing buys what production needs. Control provides the standard against which actual results are compared. Motivation sets targets people work towards, though only if those targets are seen as achievable.
That last qualification matters. A budget set at a level staff regard as impossible demotivates rather than motivates, and one set too loosely invites slack. Participation in setting the budget generally improves acceptance, at the cost of some tendency to build in easy targets.
The order of preparation
Start with the principal budget factor — the constraint everything else must fit around. For most businesses this is sales demand, so the sales budget comes first.
From sales follow the production budget, which must also allow for planned changes in inventory; then the materials usage and purchases budgets, the labour budget and the overhead budget; then the cash budget; and finally the master budget bringing everything together.
Getting this order right is examinable in itself. Planning production before knowing what can be sold is how businesses end up with warehouses full of unsold stock.
Fixed against flexed budgets
A fixed budget is prepared for one planned activity level. Comparing it against actual results achieved at a different level produces variances that are mostly just the volume difference, which tells management nothing useful about how well costs were controlled.
A flexed budget restates the budget at the activity actually achieved: variable costs are recalculated at the budgeted rate per unit, while fixed costs stay unchanged. The comparison is then like for like.
This is the single most important idea in the topic. A question giving budgeted and actual figures at different volumes is almost always asking you to flex before comparing.
Reading variances
A variance is favourable if it increases profit and adverse if it reduces it. Never label them positive and negative — F and A are the conventions, and mark schemes expect them.
More important than the label is the cause, and the most useful insight is that variances interact. A favourable material price variance achieved by buying cheaper material often produces an adverse usage variance, because the cheaper material wastes more. A favourable labour rate variance from using less skilled workers often produces an adverse efficiency variance for the same reason. Reporting the pair together is worth far more than reporting either alone.
Cash budgets
A cash budget deals only in cash, and it is the statement that most often saves a small business. It records receipts when the money actually arrives, not when the sale is made, and payments when they are made, not when the expense is incurred.
Depreciation never appears in a cash budget, because no cash moves. A capital purchase appears in full in the month it is paid for. Credit terms drive the timing: a sale in March collected in May is a May receipt.
The purpose is to identify the months where the balance goes negative, early enough to arrange an overdraft or reschedule a payment rather than discovering the problem when a cheque bounces.
Worked examples
Example 1 — Preparing a flexed budget (6 marks)
The original budget was for 10,000 units: sales $500,000, variable costs $300,000, fixed costs $100,000, giving budgeted profit of $100,000. Actual output and sales were 11,000 units.
Budgeted selling price = $500,000 ÷ 10,000 = $50 per unit. Budgeted variable cost = $300,000 ÷ 10,000 = $30 per unit.
Flexed to 11,000 units: Sales 11,000 × $50 = $550,000. Variable costs 11,000 × $30 = $330,000. Fixed costs unchanged at $100,000. Flexed profit = $550,000 − $330,000 − $100,000 = $120,000.
The extra 1,000 units were always going to add 1,000 × $20 contribution = $20,000. Flexing captures that, so it is not mistaken for good cost control.
Example 2 — Variances against the flexed budget (6 marks)
Actual results at 11,000 units were: sales $545,000, variable costs $341,000, fixed costs $104,000, giving actual profit of $100,000.
Sales variance = $545,000 − $550,000 = $5,000 A. Variable cost variance = $330,000 − $341,000 = $11,000 A. Fixed cost variance = $100,000 − $104,000 = $4,000 A. Total = $20,000 A.
Check: flexed profit $120,000 less actual profit $100,000 = $20,000 A. The variances reconcile.
Note what the fixed-budget comparison would have shown: actual profit $100,000 against original budget $100,000, a variance of nil, and the impression that everything went to plan. In fact the business sold 10% more units and still earned no more profit — which is the finding, and only the flexed comparison reveals it.
Example 3 — Interpreting the variances (4 marks)
The sales variance of $5,000 A on 11,000 units means the average price achieved was $545,000 ÷ 11,000 = $49.55, about 45 cents below the $50 budgeted — consistent with discounting to win the extra volume.
The variable cost variance of $11,000 A means the actual variable cost per unit was $341,000 ÷ 11,000 = $31.00 against $30 budgeted.
Together these say the extra volume was bought with a price cut while unit costs also rose. That is a far more useful report than "profit was on budget", and it is the kind of reading that earns the interpretation marks.
Example 4 — A simple cash budget (5 marks)
Opening cash is $12,000. Expected receipts from customers are $180,000; payments to suppliers and for expenses are $171,000. A machine costing $15,000 is to be paid for, and depreciation for the month is $3,000.
Receipts $180,000. Payments $171,000 + $15,000 = $186,000. Net movement = $180,000 − $186,000 = ($6,000). Closing cash = $12,000 − $6,000 = $6,000.
Depreciation is excluded entirely — no cash moves. The machine appears in full in the month it is paid for, not spread over its life. The business stays in funds, but only just, and knowing that in advance is the point of preparing the budget.
Common mistakes and how to avoid them
Comparing actual results with an unflexed budget. Flex first whenever activity differs from plan.
Flexing fixed costs. They stay unchanged in the flexed budget — that is what makes them fixed.
Labelling variances positive and negative. Use favourable and adverse, and state which.
Putting depreciation in a cash budget. No cash moves, so it never appears.
Spreading a capital purchase across months in a cash budget. It goes in full in the month of payment.
Recording sales in the month of sale in a cash budget. Record receipts in the month the cash actually arrives.
Reporting variances without causes. A variance is a question, not an answer; say what might have caused it.
Preparing the production budget before the sales budget. Sales is usually the principal budget factor.
How this links to your Internal Assessment
A cash budget is the single most useful thing an Internal Assessment can give a small business, because cash timing is what actually threatens them and very few keep a forward view of it.
Build three to six months forward from the records you have, applying the real credit terms the business gives and receives. Identify any month where the balance turns negative, and say what the business could do about it — bringing forward collections, negotiating longer supplier terms, deferring a capital purchase, or arranging a facility in advance rather than in a crisis.
If the business already budgets, compare a past budget against the actual outcome and flex it before comparing. Owners very often make the unflexed comparison and draw a false conclusion from it, exactly as in Example 2. Demonstrating the difference between the two comparisons using their own numbers is a strong finding.
State the assumptions behind your forecast — expected sales, collection periods, any planned spending — because a budget is only as good as its assumptions and saying so shows you understand what you have built.
Exam technique for budgeting and variance analysis
Flexing is where the marks concentrate. Set the flexed budget out in a column beside the original and the actual, so the comparison is visible and the examiner can follow it. Show the per-unit rates you derived — they are usually worth a mark in themselves.
Label every variance F or A. An unlabelled figure cannot be awarded full credit because its direction is ambiguous, and the direction is the point.
Always reconcile: the variances should sum to the difference between flexed profit and actual profit. That check catches most errors and takes one line.
Watch the command words. Prepare a flexed budget wants the restated figures. Calculate the variances wants each one with its F or A label. Explain a variance wants a plausible cause. Analyse wants the interaction between variances — the cheap material that wasted more. Evaluate budgeting as a control system wants both the planning and motivation benefits and the drawbacks of rigidity, gaming and the time it consumes, then a conclusion.
For cash budgets, rule columns by month and carry the closing balance forward as the next opening balance. Errors here are almost always a timing mistake rather than arithmetic.
Quick revision summary
- Purposes of budgeting: planning, coordination, control and motivation.
- Order of preparation: principal budget factor (usually sales) → sales → production → materials, labour, overhead → cash → master budget.
- A fixed budget is for one activity level; a flexed budget restates it at the activity achieved.
- Flex variable costs at the budgeted rate per unit; fixed costs stay unchanged.
- Variances are favourable (F) if they increase profit, adverse (A) if they reduce it.
- Variances should reconcile flexed profit to actual profit — always check.
- Variances interact: a favourable price variance often causes an adverse usage variance.
- Cash budgets record receipts and payments when cash moves, exclude depreciation, and show capital purchases in full in the month paid.
- The purpose of a cash budget is to see a shortfall early enough to act on it.
- Comparing against an unflexed budget can make a poor period look exactly on plan.